Nobel Prizes in Economics: The Gods Must Be Crazy
I THOUGHT I SHOULD pay my respects to the recent Nobel Prize winners in economics. They received sufficient press, but not the attention they truly deserve.
First, I must admit, I had never heard of Finn Kydland and Edward Prescott.
Second, I hope I never hear of them again.
Third, I was struck by the complete incoherence as to what they have done or may have contributed. Borrowing from the following days’ newspapers, these professors were “the first to ground the theories of business cycles in rigorous microeconomic theory”. I think the qualifying word there is “rigorous”. I’ll wager that we’re talking about several textbooks of equations here.
And then, the expected: “They explained a business cycle as the equilibrium outcome of rational decisions made by millions of perfectly informed individuals.”
Millions! That’s quite an assumption, but no different than silly economists have claimed for the last 50 years. Also as predictable as day following night: a state of “equilibrium”. People are not machines. The cause and effect of gravitational force does not apply to human actions. We think; apples don’t. As creatures in nature, there exists a balance or imbalance to our affairs. Historically, the greater the mutation, the greater thereversion. If lions eat all the other animals in the jungle, lions starve. In more scientific terms, this is reversion-to-the-mean.
Next on the Nobels: “Though the predictive power of the model was weak, it encouraged the economics profession to ensure subsequent theories of business cycles also had strong theoretical foundations.” Where does one start? These “subsequent theories” (if they’re better, then why give the prize to Kydland and Prescott?) are built on a theory that doesn’t work – except in theory.
Why would a theory that was “weak” be “encouraging”? Larry Summers, economicspoobah in the Clinton administration and now president of Harvard University, was asked his opinion. He offered a commendably honest, but troublingly contradictory, imprimatur: Summers said the two professors “richly deserve” the prize because of the economic methods they introduced, even though “I, like many others, find their particulartheories [about business cycles] implausible.”
Nobel Prizes in Economics: Echoes of the Past
I hear clear echoes harking back to past Nobels and their efficient market hypothesis. Of Robert Merton’s work that led to his Nobel (1997), Paul Samuelson (Nobelled, 1970) was “proud to have figured in the Mertonian march to fame” but he “could not tell if he mathematics was right or wrong”. Harry Markowitz (Nobelled, 1990) admitted that Merton’s work “has become central to much of financial theory. The one thing that bothers me is that I don’t really understand it.” (Samuelson also personifies the intriguing possibility that the Nobels have lost the faith by their actions, if not their words: in their personal investment portfolios.
He invests assets in Warren Buffett’s Berkshire Hathaway. Buffett’s partner, Charlie Munger, spoke for the pair when he described the efficient market theory as “a type ofdementia”.) Merton’s path-breaking work was based on “Ito’s Lemma”. Kiyoshi Ito,a Japanese mathematician, was feted at a dinner during which he told his audience he didn’t remember deriving the formula. Nonetheless, Nicholas Dunbar writes in Inventing Money, the “Ito machine gun would, in the capable hands of Merton, blow the big problems to smithereens, one by one.”
One David Henderson, undoubtedly craving a future jackpot from the Swedes, chatted about the work of the recently anointed Nobels in the Wall Street Journal. Kydland andPrescott “called for an independent central bank, headed by someone highly averse to inflation who would resist the government’s pressure to inflate. Just two years later, inflation hawk Alan Greenspan became chairman of the Federal Reserve Board. The result: in the last 17 years, U.S. inflation has averaged only 3%.”
Professor Henderson next supports this achievement by calling upon a measure that is not only theoretical, but states a claim that is as bogus as the Nobel Prize itself. Henderson continues: “This [the 3%] overstates inflation by one percent annually because the consumer price index fails to adequately measure for quality increases and the ‘Wal-Marteffect’ of people purchasing lowerprice items at big-box stores.” There are those who never have nor ever will, even at gunpoint, step inside a Wal-Mart store. They are fully aware that the economics of Wal-Mart shopping is efficient and rational. This does not interest them in the least.
Among other assumptions entirely believed in the economics profession, but foreign to the rest of us, Henderson restricts inflation to the price of things (assets need notapply), and employs the “substitution effect”: I eat hamburger because steak prices have risen. I still want to eat steak but can’t afford it. Most economists would say I have substituted the lower price good for the more expensive good, so prices have not risen. QED.
Nobel Prizes in Economics: The Wall Street Journal
For such academic constructions to matter, there must exist a flow of ideas, from the classroom to the local barbershop. One viaduct is the media. A case study of possibly the most influential financial medium in the US follows. The late editor of the Wall Street Journal, Robert Bartley, wrote a column in August 2002 in which he forewarned his audience: “I’ve been a partisan for efficient markets.” His partisanship was that of Dow Jones Industrial Average Brand Manager. Bartley defined efficient markets as “capital markets [that] are huge information-processing machines, and prices naturally reflect more information than any one human mind can comprehend. If markets are irrational, then how come no one systematically beats them?” Not an unreasonable question, but the efficient market hypothesis is not the topic here.
“Open your eyes” will serve. More interesting is how this approach filters through the pages of the Journal’s editorial page (not so much the news sections). The Nasdaq peaked at 5,048 on March 10, 2000. From an editorial on March 20, 2000: “We’d hope the Federal Open Market Committee [which was about to meet] would see last week’s moves for what they are: a convergence of valuations toward a more reasonable level … a reallocation of capital in favor of better value.” April 29, 2002: “Serious people can debate just what a bubble is, but if there is one, who created it?” This wariness towards the possibility of financial bubbles took another lurch two paragraphs later: “Now that the bubble has burst…”
August 2, 2002: a reply to those who argue that holding stocks in retirement accounts is a risky proposition: “Stop trying to scare people out of a good deal. Stocks have long been, and will continue to be, essential to building a secure retirement and there’s no reason to think that has changed.” Three days later Robert Bartley wrote, in his same column quoted above: “I’ve always been leery about words such as bubble, panic and crash…. [O]ver the years, I’ve found rational markets a useful first assumption.”
There is nodoubt it is useful, but the question is whether it is true. The assumptions that support the world financial structure today include Bartley’s, as well as continuous markets, rationalbehaviour, and several more in the narrative to follow. In every panic, the models – and the assumptions – have failed. Yet, they endure. The trickle down from the viaduct to the vineyard (that is, to the guy who runs the barbershop – a member of the “investor class”, to adopt the argot) certainly involves the philosophical view of the Journal’s editorial page. The circulation is near 2 million and the average reader puts faith in thepaper’s opinions about markets. The mental inclinations spill into the oped page, that portion of the editorial pages awarded to outside opinions.
The Journal does give space to the opposition, but the majority of columns are written by like-minded writers. This is natural and may be true of every newspaper. We paywriters whose ideas we admire or at least understand. One like-minded, mechanically programmed duo is James K. Glassman and Kevin Hassett, authors of Dow 36,000.
They let Journal readers in on their Trade of the Millennium before publication in 1999: “Our calculations show that with earnings growing in the long-term at the same rate as the Gross Domestic Product and Treasury bonds below 6%, a perfectly reasonable level for the Dow would be 36,000 – tomorrow, not 10 or 20 years from now.” Glassman andHassett, returning to the editorial page, September 3, 1999: “[W]hy should certain P/Es constitute a ceiling?… When you apply our model, the market looks like a gooddeal, even at today’s prices.”
Headline of a G&H op-ed, March 20, 2001: “Dow 36,000? It’s still a good bet.” Headline of a G&H op-ed, January 18, 2002: “Diversify, Diversify, Diversify.” From an articlein the Journal, July 29, 2002: “[G&S] maintain it isn’t their fault that people now focus on their optimistic title and not the caveats…. ‘If you don’t have a sensational conclusionthat follows reasonable steps, people wouldn’t pay attention,’ Mr. Hassett says….
Mr. Glassman sounds less sure about the title. ‘That’s the only thing in the book I’d consider changing,’ he says.” Perhaps bruised by that article, G&H returned to the Journal’s op-edpage two days later: “When our book, Dow 36,000 was published in September, 1999, the Dow Jones Industrial Average stood at 10,318. The Dow closed yesterday at 8,736.What went wrong? Actually, nothing.”
Snuggled into a world of assumptions they prefer, the editors of the Journal have done no favours for the investing public. This preternatural approach to the markets is, of course, the same path of most economists, Nobelled or not. Slaves to a world of efficiency, mathematical models, correlations, and calculations of every possible variable from alpha through omega, they forfeit freestyle thinking that might produce the most alarming andfrightening condition of their working lives: to be set apart from their peers.
The entire plantation brings to mind a prophecy of Wendall Berry’s. At the exact moment Glassman & Hassett’s thesis was published, he predicted: “It is easy for me to imagine that the next great division of the world will be between people who wish to live as creatures and people who wish to live as machines.”
Nobel Prizes in Economics: Merton’s Formula
Back to the efficient market hypothesis and Ito’s black tie dinner. We face a nagging conundrum of whether Robert Merton was applying a formula that had never been discovered. In any case, he received one ringing endorsement: “The mathematics … contains some of the most beautiful applications of probability and optimization theory…. [N]ot all that is practical in science is beautiful. Here we have both.” This winsome critique came from Merton Miller (Nobelled, 1990). Ecstatic in his enthusiasm, Miller pronounced, “It was really a kind of miracle to get this tremendously complicated problem reduced down to a point that a nontrivial fraction of the variation can beexplained in terms of a single factor.”
The applications of the efficient market hypothesis are ubiquitous today. These include the foundation for option pricing, indexing, portfolio insurance, and value-at-risk. Adiscussion and analysis of each in the context of the Holy Hypothesis would be superfluous, since they are mere castles in the sky.
As to option pricing theory, we must thank Fisher Black and Myron Scholes. If not for this heroic encounter, we may neverhave adopted the Black-Scholes option pricing model, without which our lives would lack much complexity engendered by derivative finance.
B&S held that equilibrium is the natural state of markets. Theirs is a charmingly simple world and it is telling that they themselves found it difficult to operate outside of theAcademy. Peter Bernstein wrote in Capital Ideas that when he met Scholes in 1972 (Nobel Prize for Economics, 1997), Bernstein told Scholes that the risk in the marketwas too great to stay put. Scholes told Bernstein (a successful money manager since the early 1950s) that that was impossible, given the efficient market hypothesis. The S&P500 fell 44% in 1973 and 1974.
Fischer Black decided to get a real job in the 1980s and went to work for Goldman, Sachs. Dunbar, from Inventing Money: “Black’s worstnightmare was an idiot savant trader who made money using a model without understanding or explaining why. As [a colleague] recalled: ‘He suggested traders at banks should be paid for the plausibility of the story they told behind the strategy beingused, rather than for the results they obtained, thus rewarding intelligence and thinking rather than possible luck.'”
Franco Modigliani (Nobel Prize for Economics, 1985) and Merton Miller brewed the Modigliani-Miller Theorem. “M&M” holds that the financial structure of a company doesnot matter; the value of a business does not change, whether its capital structure is 100% equity or 100% debt.
Nicholas Dunbar explains: “Back in the 1950s, [M&M] had shown that the value of a company should be independent of its mixture of equity and debt. If this were not so,investors could exploit the difference in share price between two separate companies, buying one and selling the other to earn a risk-free arbitrage profit.” To repeat the obvious, people are not machines; finance is not physics. People do not grind away,forever calculating this risk-free arbitrage. For one thing, no two people look at risk in exactly the same way, so there is no single point at which the arbitrage ceases to exist.
Most investors do not insistently make the same losing trade until they are bankrupt. (This is not to be confused with those who dispense consistently losing financial advice,such as Glassman and Hassett.)
Milton Friedman (Nobelled, 1976) stated that chaotic speculation is impossible, because people who bought high and sold low would soon enough lose it all. He should have taken a sabbatical at a trading desk. How much we owe M&M for the leveraged-buyout craze and the highly leveraged, corporate balance sheets of today would be speculationon my part.
Nobel Prizes in Economics: The Efficient Market Hypothesis in Action
We have weathered the fruits of the efficient market hypothesis in action. Portfolio insurance was the brainstorm of Barr Rubenstein and Hayne Leland, professors at Berkeley. They designed it to prevent a market loss below a specified percent over a specific time. One laboratory assumption proved fatal. Peter Bernstein described this theoretical requirement:
The assumptions underlying portfolio insurance (and the option pricing theory on which it is based) underwent a crucial test in October 1987. For the strategy to be fully effective, the investors without portfolio insurance must accommodate the investors with portfolio insurance, at all times and under all conditions. Changes in stock prices must be continuous – a stock cannot close at $25 and open the next day at $22. And the market must be willing to absorb whatever is necessary at prices very close to the priceprevailing when the sell decision is made.
Portfolio insurance was a big hit among institutional investors. Leland, O’Brien, and Rubinstein (LOR) guzzled fees from happy customers. The 1987 crash exposed the fragile (and preposterous) assumptions imbedded into their product. Portfolio insurance played an important role, possibly the dominant role, in the crash. Their clients may have suffered, but LOR’s principals still floated through the boom phase of their theory.
New customers were scarce, but their thesis stood tall, at least in the locker room at Leland, O’Brien, and Rubinstein. Leland said of those who stuck with portfolio insurance: “…[T]hey took the time to more fully understand the product. They realized that the problems of portfolio insurance in the crash were related to problems of market liquidity, not to some ‘fundamental flaw’ of the underlying technique.”
Likewise, Rubinstein dismissed the market as not living up to his high standards. “[T]he market was nice enough to provide proper conditions for more than 50 years.” In other words, the 1987 crash was programmed to occur once every billion years or so; it happened to show up on LOR’s watch.
Another once-every-billion years’ meltdown was Long-Term Capital Management (LTCM) in 1998. John Meriwether, star trader at Salomon Brothers, took his Salomoncolleagues and set up shop, adding two Nobel Prize winners (Scholes and Merton) to the staff. By 1997, it employed 25 Ph.D.s, whose province was constructing highly quantitative arbitrage trades. The law of diminishing returns was closing in and the Ph.D.s were finding less opportunity to apply their skills.
Investors received 44% returns in 1996 (a doubling of the initial investment), but only 17% the following year. LTCM “had moved from highly quantitative arbitrage trades to outright gambling on currencies and stocks. Myron Scholes questioned whether LTCM really had an advantage in such areas, and wondered if the firm was assessing risks properly.”
LTCM’s problem was that Scholes didn’t wonder enough. (It may be questioned whether he wondered at all, or even had the capacity to wonder. When accepting the NobelPrize in 1997 in Stockholm, he singled out two companies – General Electric and Enron – as having the ability to outcompete existing financial firms and noted, “‘Financial products are becoming so specialized that, for the most part, it would be prohibitively expensive to trade them in organized markets.’
According to Scholes, Enron’s trading of unregulated and over-the counter energy derivatives was a new model that someday would replace the organized [and regulated]securities exchanges.” (Quoted from Frank Partnoy’s Infectious Greed.) His models did not accurately predict the consequences of an exodus and the (predictable) illiquidity. More specifically, the models’ risk exposure was measured by a value-at-risk(VaR) computer model. (VaR was a newer calculation used to measure portfolio risk. It is still commonly used today. It deserves a fuller explanation, but this is not the place.
Rather, under discussion is the repetition of the same mistakes, again and again, with new models built upon the same, bogus assumptions.) LTCM’s models predicted that themaximum loss LTCM would suffer in a single day (within the specified probabilities, etc., etc.) would be US$45 million. As risks mounted, the firm decided to reduce its VaRfrom US$45 million to US$35 million. They sold some of the less desirable securities, rechecked the models, and found that the new VaR was US$100 million. They hadn’tproperly accounted for real-life trading and how mayhem affects the relationship of security prices. (Recall Leland’s claim that portfolio insurance possessed no fatal flaw: the meltdown was a “liquidity problem”.)
Once again, the Nobel minds at LTCM come up short when the assumption of continuous markets – as explained earlier by Peter Bernstein – would not, and cannot, be modelled.
What did the participants learn? As with Leland, O’Brien, and Rubinstein, not much. This was another “once in the history of the universe event”. John Meriwether believed that “[his] approach was validated by the market crisis that brought down his fund”. Meriwether told the Financial Times: “I would say that August and September 1998proved to me that there are great opportunities in relative value trading because of [the] herd instinct.” Sure, but not for LTCM since it led the herd. According to Martin Meyer, “John Meriwether … had no notion how many other people were following the same strategies. But imitation is not only the sincerest form of flattery – it is also the most likely form of flattery.”
Nobel Prizes in Economics: “An Entire Industry of Risk Measurers”
In Fooled by Randomness, Nassim Nicholas Taleb, a quantitatively trained and successful options trader, is dismissive of “an entire industry of risk measurers” who apply “probability methods to assess risks in the social sciences”. The odds are computable for a card game with clearly defined rules; however, “mother nature did not endow us with clear rules … but somehow people ‘measure’ [financial] risks, particularly if they get paid for it.”
From a practical view, Taleb wonders what is the story with the LTCM failures. They “put the blame on a rare event … and spent their energy defending themselves rather thantrying to make a buck with what they learned.”
Taleb reminds us that there is no Nobel Prize in Economics. This was a tag-along deal established by the Riksbank. Sweden’s central bank funded the prize for economic science in memory of Alfred Nobel. A central bank isn’t the type of sponsor that encourages novel thinking.
A country gets the politics it deserves, and a bureaucratic, conventionally minded, committee-driven, man-inthe- grey-flannel-suit institutionhonours like-minded economists that it reveres. David Henderson reminds us just how chummy is this reflected glory when he wrote that Kydland and Prescott “called for anindependent central bank, headed by someone highly averse to inflation who would resist the government’s pressure to inflate”.
One other note. That is on science. The Riksbank established a prize in “economic science” (a long way from its origins in “political economy”), when there is no scienceat all. In Frozen Desire, James Buchan’s splendid discussion of the nature of money, the author writes: “that economists … can explain neither prices nor the rate of interestnor even agree on what money is reminds us that we are dealing with belief not science.”
But even the hard sciences are moving into matters of faith, not science. Superstring theory is the rage today in physics. George Johnson described its development in the New York Times. Igor and Grichka Bogdanov have conjured up an idea “that is so dumbfounding, so convoluted, so completely off the wall that it leaves their challengerswith mouths agape. With no way toget a grip on the slippery mathematical emulsion, verification seems impossible…. As theorists explore the possibility of extra dimensions and spaces that bend, twist themselves in knots, they can never be certain whether they are just conjuring with numbers or talking about something real.”
Johnson moves on. (We are on our home turf here. The similarities between string theorists and their mentors recall parallels to many an economic Nobel.) The Bogdanovbrothers “have developed their own private language”. Recent topicality was propelled by their Ph.D. thesis.
Trying to follow the arguments between the physicists and the Bogdanovs is “like trying to nail Jell- O to the wall”. A diffident, though prominent, string theorist opines: “Ido think it is possible to tell good work from bad. Even when researchers are confused, and only have a partial understanding of a puzzle, it is important that their arguments would have some element of logic and consistency.” Maybe so, but physicists as a whole “seem to have accepted that the papers are probably just the result of fuzzy thinking, bad writing and journal referees are more comfortable with correcting typos than challengingthoughts”.
I cannot recall The Chairman extolling the efficient market hypothesis. Whatever his stand, Greenspan’s veneration of derivatives puts him squarely in the Nobels’ camp, like it or not. A paradox here is the assumption of a world full of “perfectly informed individuals” betting so heavily on the views of one man. It happens that this one manwarned Fortune readers of an “overexuberant” stock market in 1959 (the bull market had seven more years to run); informed New York Times readers in January 1973, “It is veryrare that you can be as bullish as you can now” (the immediate response of the S&P 500 was to fall 44%); missed the 1990 recession entirely, never mentioning it until 1994 testimony when he complemented the Federal Reserve for having taken promptaction before the downturn, in 1989 (rather unsporting of him not to have told us about it); still does not know if there was a stock market bubble in 1999, and still does not know if he can ever identify a bubble; and, in 2004, donned the attire of mortgagebroker when he told the public it really should investigate new variablerate mortgage products.
That this perfectly informed public has since splurged on variable-rate mortgages is not reassuring. (This is the same public – the “ownership society” -legislators may soon grant the responsibility to manage their own social security accounts. And what does it own? This perfectly informed ownership society hands over any increment of home equity a greedy banker will take off its hands.)
To bring us up to date, Eugene Fama, conjurer of the EMH, believes as strongly as ever that his theory stands whole: “[W]e don’t know enough about the way in whichinformation gets incorporated into prices. But if you look at the crashes, half of them turn out to be too small and half turn out to be too big.” An inverse relationship seems to existbetween the precision of the calculations and the ambiguity of the claims.
Keeping with this theme, there is Vernon Smith (Nobel Prize for Economics, 2002) who won his award for “simulating trading behavior in laboratories, [showing] how financialbubbles are created”. (Why he didn’t look outside the classroom door to participate in the real thing remains a mystery.)
Nicknamed “Professor Bubble” by Forbes magazine, Smith dismissed the notion of a posttechnology bubble. “[T]he memories of the 2000 debacle are too fresh for investors to spin out of control this time. ‘New bubble danger comes down the road when a new generation of investors joins the market.’ Smithsays.” If so, his job is done, at least for the next 30 years. Why show up to work in the morning?
If Fama and Smith don’t successfully confuse the spectator, an article by two physicists in Quantitative Finance may. They have “applied the methods of statistical physics to the markets” and have discovered an “anti-bubble”. Published in the fall of 2002, thephysicists demonstrated that the US stock market would fall 30% by December 2004 (from that low point in 2002). The authors planned to “start an industry in this area”. Thatthe stock market rose 55% over that period may not have deterred their money-making ambitions. This, of course, has been the path all our Nobels pursued, to varied success, but have invariably received personal financial gain.
At the 2003 Berkshire Hathaway annual meeting, Charlie Munger saw no good end to the derivatives pyramid. “I think a lot of counterparties are behaving in [a dangerous way]. In engineering, people put big margin-of-safety factors in place…. But in the derivatives markets, it’s as if nobody gives a damn about safety. They just balloon and balloon, and it’s aided by false accounting…. I’ll be amazed if I live another five to ten years and we don’t have a major blowup.”
Eugene Fama replies to his critics that, “[t]oday, there are 10,000 financial academics looking for violations of one theory or another, including efficient markets. I think ithas stood up pretty well.” Ten thousand of them! (And US productivity is rising?) James Buchan has the last word: “I have watched the most able men and women of mygeneration, who might have created unexampled monuments in moral philosophy, mathematics, or engineering, waste their time in prattle of non-accelerating inflationrates of unemployment or rather, since such matters cannot long occupy an educated mind, in interminable telephone conversations with their stockbrokers [Fama, and the Nobels dropped the classroom for the investment management business.]….[E]conomics has retreated into algebra. A profession that begins with priests [alchemists] … ends withhermits. Political economy is now, I suspect, in the same condition as scholastic learning found itself on the eve of the Discoveries. It is about to explode.”
March 16, 2005